The Nest

NestApple's Real Estate Blog

Featuring real estate articles and information to help real estate buyers and sellers. The Nest features writings from Georges Benoliel and other real estate professionals. Georges is the Co-Founder of NestApple and has been working as an active real estate investor for over a decade.

What is a 1031 Exchange: tax benefits and everything you need to know.

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Saving money with a 1031 Exchange - brokers showing an apartmentWhat is a 1031 tax-deferred Exchange? What are its benefits? Real estate investing can feel like a dream sometimes. Your property is appreciating; you claim depreciation on your income taxes. They’re cash-flowing and providing extra income for your family. What investors can be surprised to hear are the taxes they’ll owe when they sell. With regular investments like stocks and bonds, you pay capital gains. It is the difference between your purchase price and your final sale price. Unfortunately, there’s much more to consider when it comes to investment properties.


Investors can be surprised to learn when they sell that depreciation recapture is also taxed at higher rates! Not only will you owe capital gains and depreciation recapture, but you could also owe even more for attached items that have a faster depreciation schedule. If you’ve never heard of depreciation recapture, this article is for you. First, we’ll look at an example of the average real estate investor and the taxes they’ll owe. Then, we’ll explain the 1031 exchange tax benefits in detail. You’ll walk away with knowledge about how to reduce real estate taxes the next time you sell a property.

1031 tax-deferred Exchange Example – More Tax Benefits than you think

How much money can you save by using a 1031 Exchange?Let’s say a fictional investor, “Shayna,” is looking to sell her investment property. It’s a triplex in Kansas City, MO, that she bought ten years ago for $400,000. Shayna initially allocated $360,000 to the building’s value and $40,000 to the land.

Since you cannot depreciate land, $360,000 will be deducted in equal amounts for 27.5 years. Shayna has taken $13,333/year of depreciation or $1,111/month for the past ten years.

The first ten years Shayna’s owned the property have been great! It has cash-flowed $200 a month and appreciated a lot. The fair market value is now $600,000! Even better, Shayna has taken $133,333 in depreciation, which has reduced her income in the eyes of the IRS. The only bad part is when Shayna goes to sell the property. Her accountant says her tax bill will be $73,333.25. Shocked, Shayna wonders how this could be when the property has only appreciated by $200,000. She figured that since it’s a long-term capital gain, the tax rate would be (.2*200,000)=$40,000.

Why is the tax higher than expected?

What Shayna didn’t realize is that when “The IRS giveth, the IRS taketh away.” Shayna has been enjoying a depreciation-fueled tax break for the past ten years. Now, the IRS wants that money back upon sale. Here’s how the IRS figures this out:

Jar with cash - What is a 1031 ExchangeIn addition to regular capital gains (Sale Price – Original Price), the IRS says that any depreciation you take makes your “cost basis” lower. Using Shayna’s example, instead of the original cost basis of $400,000, the IRS “cost basis” is $266,667 (Original Price – Depreciation Taken). To add insult to injury, depreciation recapture is taxed at your regular income tax rate, up to 25%. Our examples assume your long-term capital gains rate is 20%, and depreciation recapture is 25%.

So when Shayna sells her property, she should be accounting for the capital gain of $200,000, taxed at 20%. Then, she needs to add depreciation of $133,333 taxed at 25% to this total. Seem unfair? It might be, but the IRS isn’t in the morality game. They don’t care if you helped ten old ladies across the street last week; they want their money.

1031 tax-deferred Exchange Tax Benefits

Who wants to pay $73k to the IRS when you sell a property? Not many hands up in the room.

Numbers on spreadsheets - What is a 1031 ExchangeFortunately, there’s a way to defer paying taxes upon sale, and that’s through the 1031 exchange. You can buy a “replacement property” and not pay a single dime to the IRS by arranging with a qualified intermediary. It is not a loophole, and it’s not a new technique. The 1031 exchange has been around since the 1980s, and hundreds of thousands, if not millions, have been done in total. We’ll walk through the basics.

When you are preparing to sell your existing property, you should reach out to a qualified intermediary for a consultation. They’ll help you document all the necessary steps during the process. You should decide if a 1031 exchange is right for your situation before the sale of your current property is complete. If you think it is, you’ll need to identify replacement properties within 45-days of the sale. Identification means that it’s a suitable property and worth more than the proceeds from your existing property.

After identifying the properties, you must close on one of these replacements within 180 days of the sale. Once you’ve done this, you’ll submit form 8824 on that year’s taxes. There are quite a few steps that we’ve glossed over, but any reputable 1031 exchange company will help you through all of them.

You may be asking, “won’t I just have a huge tax bill someday?” The answer is, “it depends.” There are ways to do 1031’s until you die continually. The crazy part is that your heirs receive the properties on a step-up basis. It requires in-depth knowledge of 1031 and some help from CPAs and estate planners.

Written By: Georges Benoliel

Georges has been working in Wall Street for the last 16 years trading derivatives with hedge funds. He has been an active real estate investor for over a decade. Georges graduated from HEC Business School in Paris and holds a master in Finance from ESADE Barcelona.

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